The Bankruptcy Partition

Corporate bankruptcy law is built around the idea of replicating the hypothetical bargain that would occur among creditors of a firm if they could all negotiate ex ante. By the common account, the creditors in that bargain would agree on a set of rules that maximize value. In our working paper, “The Bankruptcy Partition,” we introduce an important qualification to this idea. When investors gather to invest in a common venture, their focus is on maximizing the value of that particular venture, rather than maximizing their total wealth as a group. The focus of the hypothetical creditors’ bargain, then, is similarly limited. The bankruptcy partition draws the line that defines the assets and procedural forum that fall within that focus.

This foundational point has been absent in many recent bankruptcy debates. Indeed, we suggest that concentrating on the partition and establishing a framework for what lies inside and outside the bankruptcy partition can largely moot a recurring debate in the courts and the academy: whether the bankruptcy judge should enjoy the discretion to depart from bankruptcy’s distributional rules. We suggest that once the dynamics of establishing and policing the bankruptcy partition are taken into account, there is little room for departures from bankruptcy’s distributional rules.

Using examples from recent high-profile debates in bankruptcy cases—from critical vendor orders to the Supreme Court’s decision last year in Jevic—we show that most analyses have mistakenly focused on distributional questions without first identifying which assets and procedural rights fall with the bankruptcy partition. What appear to be distributional disputes are more often debates about the demarcation of the bankruptcy partition and the best way to police it.

After establishing the core importance of the partition, we then provide some guidance in locating it. On the asset side, at first approximation, the line is easy to draw. The assets available to the general creditors of a common debtor in bankruptcy are those available to firms under non-bankruptcy law. The bankruptcy judge has no power to bring other assets into the estate merely because appropriating such assets would make the creditors better off. Moreover, everyone’s focus is supposed to be on maximizing the value of the assets in the estate and not on how decisions might improve the outside interests or fortunes of particular stakeholders.

But the bankruptcy partition also encompasses a procedural forum that resolves the rights of stakeholders. The power of this forum can extend beyond disputes about assets of the bankruptcy estate. And the precise line can be difficult to draw. Claims a creditor has against the debtor are almost always resolved in bankruptcy. Rights two creditors have against each other that are unrelated to their stakes in a common debtor are not. Other matters are less clear. It is important, however, to ensure that sorting out rights among stakeholders in the bankruptcy forum is aimed at a core bankruptcy purpose and does not bring benefits to general creditors that they would not receive outside of bankruptcy.

As an example of this application of the bankruptcy partition to procedural questions, we explore the recent controversies over third-party releases. In the extreme, orders that simply release one group of stakeholders from claims held by other third parties can be viewed as attempts by the estate to commandeer assets that are outside of the partition. Without more, such actions cannot be justified by a bankruptcy purpose. But there will be cases where, although the assets lie outside the partition, there are procedural considerations that might bring the conflict within the partition. For example, the debtor may be able to confirm a plan only if it can resolve a dispute with a third party, but the third party might be willing to settle only if it can also settle with one or more other creditors of the debtor who have independent causes of action against it. This provides a hold-out opportunity to those other creditors.

One can argue that overcoming such hold-out problems is appropriately done in bankruptcy. Bankruptcy exists to consolidate the affairs of multiple creditors and a common debtor in a fashion that facilitates the resolution of disputes among them. Expanding the bankruptcy partition to include the power to settle such disputes and to eliminate hold-out problems among the creditors is exactly the type of procedural mechanism that would be at the heart of the hypothetical ex-ante bargain among creditors.

Of course, the court will want assurances that the release is, in fact, addressing a hold-out problem and not commandeering value. Class voting requirements or compensation rules can address this. One might require the judge to find explicitly that the dissenting creditors were receiving benefits from the plan that compensated them for what they were losing by virtue of the release. An independent assessment of whether the parties subject to a release are being compensated is akin to the best-interest-of-the-creditors test that protects dissenters in the Chapter 11 voting process. With that protection, bringing the resolution of such claims into the bankruptcy process can be defended in a straightforward way as a coherent extension of the creditors’ bargain and analogous to the way bankruptcy law treats security interests with the statutory rules behind cram-down.

All of this is to say that a clearer focus on the bankruptcy partition in resolving these and other close-to-the-partition questions will lead courts to better understand what is at stake.

This post comes to us from professors Douglas G. Baird, Anthony J. Casey, and Randal C. Picker at the University of Chicago Law School. It is based on their recent paper, “The Bankruptcy Partition,” available here.